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With reference to Convertible Bonds, consider the following statements: 1. As there is an option to exchange the bond for equity, Convertible Bonds pay a lower rate of interest. 2. The option to convert to equity affords the bondholder a degree of indexation to rising consumer prices. Which of the statements given above is/are correct?
Explanation
The correct answer is Option 3 (Both 1 and 2). This is because convertible bonds offer a unique blend of debt and equity features that benefit both the issuer and the investor.
- Statement 1 is correct: Convertible bonds typically offer a lower coupon rate (interest) compared to non-convertible bonds. This is because the "embedded option" to convert the debt into equity shares is a valuable benefit. Investors accept a lower fixed income in exchange for the potential capital appreciation of the company's stock.
- Statement 2 is correct: These bonds provide a hedge against inflation (indexation to rising prices). In inflationary periods, consumer prices and company earnings generally rise, leading to higher stock prices. Since the bondholder can convert to equity, they can participate in this growth, preserving purchasing power better than a fixed-income bond, which loses value as inflation rises.
Therefore, both statements accurately describe the financial mechanics and strategic advantages of convertible bonds, making Option 3 the right choice.
PROVENANCE & STUDY PATTERN
Guest previewThis question tests financial common sense ('No Free Lunch' theorem) rather than rote memory. It separates aspirants who know definitions from those who understand the *mechanics* of risk and return. If you get a benefit (equity option), you must pay a price (lower interest).
This question can be broken into the following sub-statements. Tap a statement sentence to jump into its detailed analysis.
- Statement 1: Do convertible bonds typically pay lower coupon rates than comparable non-convertible bonds because bondholders have the option to convert the bond into equity?
- Statement 2: Does the conversion option in convertible bonds provide bondholders with indexation or protection against rising consumer prices (inflation)?
- Explicitly states convertibles offer a lower coupon rate in exchange for the conversion option.
- Directly ties the lower coupon/return to the value of the option to convert into common stock.
- Says convertibles are typically offered with a lower coupon than comparable non-convertible debt.
- Explains the issuer benefit (paying less in interest) due to the conversion feature.
- Notes the conversion option gives equity upside, and because of that upside convertibles typically offer lower yields than comparable bonds.
- Frames the lower yield as a trade-off for the equity-linked benefit to bondholders.
The snippet explicitly states the proposition as a textbook exam statement: 'As there is an option to exchange the bond for equity, Convertible Bonds pay a lower rate of interest.'
A student could treat this as a stated principle and then check market examples or compare issuer coupon schedules to test if convertible issues indeed show lower coupons than plain debt from same issuer.
Explains instruments that convert into equity (convertible debentures, warrants) and highlights that conversion is a right/feature tied to debt instruments.
Knowing conversion is a built-in equity option, a student can reason that such an option has value to holders and therefore may allow issuers to offer lower interestâso they could compare option value to coupon differential.
Describes how bond yields and prices reflect expected returns relative to alternatives, showing bond coupon/yield trade-offs matter in pricing.
Combine this pricing rule with the conversion feature's value: if conversion adds expected upside, required coupon (and yield) could be lower for equivalently priced convertible bonds.
Defines different bond types (fixed vs floating vs indexed), indicating bonds' coupon structure varies with attached features.
A student can generalize that additional bond features (like convertibility) are part of bond design that influence coupon levels and can compare feature-rich bonds to plain fixed-rate bonds.
Notes that bonds give fixed returns and that fixed-income holders bear certain risks (e.g., inflation), underlining that bond returns are adjusted for risk/benefit trade-offs.
A student could infer that because convertibility provides potential equity upside (mitigating some fixed-return disadvantages), issuers might compensate by offering lower fixed coupons.
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